Macroeconomic Surprises and Stock Market Responses

Cogent Economics & Finance
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Macroeconomic surprises and stock market

responses—A study on Indian stock market
Santanu Pal & Ajay K Garg |
To cite this article: Santanu Pal & Ajay K Garg | (2019) Macroeconomic surprises and stock
market responses—A study on Indian stock market, Cogent Economics & Finance, 7:1, 1598248,
DOI: 10.1080/23322039.2019.1598248
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Pal & Garg, Cogent Economics & Finance (2019), 7: 1598248
https://doi.org/10.1080/23322039.2019.1598248
FINANCIAL ECONOMICS | RESEARCH ARTICLE

Macroeconomic surprises and stock market
responses—A study on Indian stock market
Santanu Pal1* and Ajay K Garg2
Received: 17 January 2019 Abstract: This study analyzes the sensitivity of a series of Indian stock indices for
Accepted: 18 March 2019
the astonishing component of monetary and macroeconomic policy with the data
First Published: 22 March 2019
set from 1 April 2004 to 31 July 2016. The immediate impact is assessed with event
*Corresponding author: Santanu Pal,
Indian Institute of Management analysis, and the dynamic effect is analyzed with the Vector Autoregression (VAR)
Lucknow, Noida Campus, B-1, Sector- model. The result of the event analysis indicates that the monetary policy surprise
62, Institutional Area, Noida 201 307
E-mail: efpm03007@iiml.ac.in significantly affects the stock market and is more prominent than that of other
Reviewing editor:
macroeconomic surprises. Unlike the event study, the VAR analysis found that the
Damir Tokic, International University other macroeconomic surprise also affects stock return. The study also highlights
of Monaco, Monaco, Monaco
the industry effect and size effect, which is coherent with the predictions of the
Additional information is available at
the end of the article
CAPM (Capital Asset Pricing Model) model. While many studies have been conducted
on the monetary policy surprise in the developed economy, there are relatively few
studies on macroeconomic surprises. Some studies conducted in India have ana-
lyzed the impact of monetary policy surprises on stock price; however, to the best of
our knowledge, none of the studies has examined the simultaneous effect of both
macroeconomic and monetary policy surprise. The study is relevant because the
responses differ across sectors and vary with firm sizes. Thus, the study can effec-
tively be used as a hedging instrument. Furthermore, the stock market acts as
ABOUT THE AUTHORS PUBLIC INTEREST STATEMENT

Santanu Pal is a fellow researcher in Indian The paper explores the sensitiveness of stock
Institute of Management Lucknow. His research returns in relation to both monetary policy and
interest is in macroeconomy and firm-level macroeconomic surprises. For this study, the
interactions. He is reachable at efpm03007@iiml. sensitivity of a variety of Indian stock indices is
ac.in considered in relation to unanticipated move-
Ajay K Garg is an associate professor in Indian ments of macroeconomic indicators such as
Institute of Management Lucknow. His research monetary policy, price indices, growth rates,
interest lies in earnings management, public industrial production, and current account.
issues, and value creating restructuring strate- Through the use of different measures of mone-
gies. He can be reached at ajaygarg@iiml.ac.in tary policy and other multiple macroeconomic
surprises, the unanticipated elements of the
monetary policy variable and other macroeco-
nomic indicators are isolated. For estimating the
Ajay K Garg sensitiveness of stock returns to monetary policy
and macroeconomic surprises, we have consid-
ered 20 indices. In the Vector Autoregression
analysis, all the surprises are considered as exo-
genous variables, and the dynamic effect high-
lights that the impact of surprise variables is
primarily at the shorter horizons, instantly after
the shock, and is diminutive over the period;
however, the recovery period varies with industry
category and type of surprises.
© 2019 The Author(s). This open access article is distributed under a Creative Commons
Attribution (CC-BY) 4.0 license.
Page 1 of 31
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a vital channel for policy transmission and a critical decision driver for corporate
finance. The understanding of firm and stock market dynamics against macroeco-
nomic surprises can help policymakers in enhancing policy effectiveness and cor-
porate finance professionals in improving decision-making.
Subjects: Economic Theory & Philosophy; Monetary Economics; Corporate Finance; Credit &
Credit Institutions; Investment & Securities; Financial Management; Critical Management
Studies
Keywords: macroeconomic surprise; monetary policy surprise; stock market response;

event study; VAR; India
1. Introduction
On theoretical grounds, the stock prices equate with that of the estimated value of the total future
cash flow. Therefore, it is evident that positive increase in macroeconomic and monetary policy
results in the enhancement in stock returns, which is indicative of the escalating future cash flows
or declining discount factors for the benefit of cash flows through the support of positive macro-
economic and monetary policy.
The financial markets do not have complete information, and so they take a forward-looking
view. For the futuristic observation, they constantly monitor macroeconomic development and
monetary policy stance. Any deviation from the expectation comes as a surprise, and it is
supposed to be reflected in the market price.
The paper explores the sensitiveness of industry-specific stock returns in relation to monetary
policy and macroeconomic surprises. For this study, the sensitivity of a variety of Indian stock indices
is considered in relation to unanticipated movements of macroeconomic indicators such as mone-
tary policy, price indices, growth rates, industrial production, and current account. There are three
motivations for evaluating the stock market reaction to macroeconomic and monetary policy
surprises. First, considering the perspective of monetary and macroeconomic policy, stock markets
are part of the transmission mechanism, so policymakers can be benefitted for comprehending
this channel, as it will enable them to examine and augment the efficiency of monetary and
macroeconomic policy. Second, in corporate finance, it is crucial to understand the fundamental
reasons for stock market movements and their heterogeneity because stock performances gen-
erally decide the strength of the balance sheets, and its understanding can improve the decision-
making. Third, for an investor, it is advantageous to be acquainted with the performance of specific
stocks and to develop an obvious idea about the influence of macroeconomic events on sector-
specific, size-specific, and general stock market indices because most of these indices act as
benchmarks for assessing the performance of existing investments, taking position for future
index investment, and designing financial instruments such as options and derivatives.
The response of stock prices to monetary policy is heterogeneous in nature and is well
researched. The stock market response on monetary policy relies on firm characteristic and the
credit channel that a particular firm is accessing (Bernanke & Blinder, 1992; Ehrmann & Fratzscher,
2004; Kashyap, Lamont, & Stein, 1994; Kashyap, Stein, & Wilcox, 1993). The heterogeneity of the
response also varies with firm size owing to its association with the risk perception (Benanke &
Gertler, 1989; Kiyotaki & Moore, 1997). The heterogeneity of the impact of monetary policy also
comes from the industries (Bernanke & Kuttner, 2005; Dedola & Lippi, 2005; Ehrmann & Fratzscher,
2004; Ganley & Salmon, 1997; Hayo & Uhlenbrock, 2000).
While many studies have been conducted on the ways in which monetary policy influences the
stock market, only few studies have recorded the stock market returns relation with other macro-
economic variables. At the country level, for instance, Maysami, Howe, and Rahmat (2005), Ewing
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(2002), Gupta and Reid (2013), Kyereboah-Coleman and Agyire-Tettey (2008), etc., have developed
the relationship between stock market performance and different macroeconomic variables.
However, in India, previous studies, such as Ghosh (2009), Bhattacharyya and Sensarma (2008),
Pal and Mittal (2011), Singh and Pattanaik (2012), Sengupta (2014), and Prabhu, Bhattacharyya, and
Ray (2015), have mainly focused on the impact of either monetary policy or macroeconomic factors
on stock prices. It is probably the first study on India that scrutinizes the simultaneous effect of both
monetary policy surprise and wide range of macroeconomic surprises on stock returns.
Besides the lack of research in this field, the analysis in the Indian market is also important for
several reasons. First, according to the International Monetary Fund data, in terms of Gross
Domestic Product (GDP), India occupies the seventh position in the world. However, considering
the purchasing power parity, India occupies the third position and comes after China and the
USA. Second, from 2000 to 2016, India has shown an average real GDP growth of 7.1%, thus
becoming one of the fastest developing countries. Third, compared to the other developing nations
of Asia, the Indian economy is more balanced because of large private consumption and less
dependency on exports. India’s “exports of goods and services“ as a percentage of GDP was only
24% in 2008 and 19% in 2016, which was far less than 36% of Developing Countries in Asia as
a whole in 2008 and 24% in 2016.1 Fourth, India’s financial system is robust and well regulated.
Central bank and capital market regulator supervise the financial activities. It remained compara-
tively unscathed even at the time of the global financial crisis. Compared to the developed world,
the shortcoming of the Indian economy was far better contained. The real GDP was almost 6.2%
even during the global financial crisis in FY08 to FY09. Fifth, though India is mainly dependent on
a bank-based system, by carrying out notable institutional and technological reforms, India has
made an energetic stock market. Together with the Bombay Stock Exchange (BSE) and the
National Stock Exchange (NSE), the average daily stock market turnover in 2016 was Rs.
203 billion (USD 2.9 bn).2 As on 31 March 2016, market capitalization was Rs. 94 trillion (USD 1.4
trillion) for BSE and Rs.93 trillion (USD 1.4 trillion) for NSE.3 Indian stock market is also quite vibrant
with the presence of Foreign Portfolio Investors (FPIs) and Foreign Institutional Investors (FIIs).
Participants are active in all forms of market instruments, viz., debt, equity, and derivatives—Index
Futures, Index Options, Stock Futures, Stock Options, and Interest rate futures. For example, on
31 March 2016, the gross purchase of equity was Rs. 59 billion (USD 0.98 billion) and gross sale of
equity was Rs. 44 billion (USD 0.73 billion)4 . This combined trade was approximately 50% of the
average daily turnover of BSE and NSE. Lastly, there are several monetary policy interventions in
the last few years to attain India’s key economic objectives, namely, Price Stability, Economic
Growth, Full Employment, and Maintenance of Balance of Payment. During different instances, the
Reserve Bank of India (RBI) has introduced different instruments and indicators to achieve these
objectives. For example, the RBI introduced Term Repo in 2013 to inject liquidity over a period
longer than overnight. Market Stability Scheme in 2004 was also introduced for absorbing surplus
liquidity through the sale of short-dated government securities, etc. The RBI has also changed
indicators for monetary policy decision, i.e., while framing the monetary policy in 2014, the RBI
transformed to a flexible inflation targeting framework from the multiple indicator approach. In
the new framework, consumer price index (CPI) inflation is the nominal anchor; however, before
the shift in 2014, the monetary policy was related to the movements in wholesale price index
(WPI) inflation. Therefore, more research is needed with a focus on the macroeconomic policy, and
hence, India has been taken as a focus country for investigating the relation of macroeconomic
surprises with the stock market.
The present study aims to provide the first empirical evidence on the effect of both monetary
policy and macroeconomic surprises on stock returns in India. This study investigates the effect of
macroeconomic surprises on stock returns in India by following two different approaches—Event
Study and Vector Autoregression (VAR). In VAR, we adopted the methodology of Bernanke and
Kuttner (2005), but the paper is different in two ways. First, Bernanke and Kuttner's (2005) focus
was on the developed economy, such as the USA, but our focus is on an emerging economy, viz.,
India, where the dynamics of the stock market and its transmission mechanism show a notable
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difference from the developed economies. Second, Bernanke and Kuttner (2005) VAR approach
analyzed the effect of monetary policy surprise, but by augmenting their approach with both
monetary policy and other macroeconomic surprises, this paper separates the surprise elements
of the monetary policy variable and other macroeconomic indicators while analyzing the effect of
these surprises on stock returns in India.
Section 2 provides a literature review, and Section 3 presents the data and methodologies
employed, especially the construction of the macroeconomic and monetary surprise variables.
Section 4 focuses on the event study, while Section 5 on VAR analysis. Finally, Section 6 provides
the conclusion.
2. Literature review
The good forecasters of real variable are interest rate, stock market, and spread between commer-
cial rate and policy rate, as these variables provide crucial information. Financial market dynamically
incorporates information on macroeconomic decisions to forecast the business environment and
make a prudent financial decision, which is expected to be reflected in the stock price movement.
The stock market influences the macroeconomy through two channels. The first channel is that
the changes in stock prices affect the cumulative consumption via the wealth channel of house-
hold (Keynes’ General Theory; Gilbert, 1982; Modigliani, 1944 &, 1971 etc.). The second channel is
the effect of stock price movements on the cost of capital (Keynes’ General Theory; Tobin, 1978;
Modigliani, 1971, etc.) The stock market movements play a vital role in determining the decisions
related to monetary policy owing to their probable effect on the macroeconomy. Mostly, the
impact of equity prices on monetary policy is not precisely related to the influence of policy on
the real interest rate. Instead, the policy surprises affect stock prices, which is evident through its
impact on the expected future excess returns or expected future dividends.
The response of stock prices to monetary policy is heterogeneous in nature, and understanding
of heterogeneity is important for policymakers and other market participants such as corporates
and investors. The stock market response on monetary policy is dependent on firm characteristic
and the credit channel that a particular firm is accessing (Bernanke & Blinder, 1992; Ehrmann &
Fratzscher, 2004; Kashyap et al., 1994, 1993). Liquidity and leverage are the two important firm
characteristics for maintaining heterogeneity in monetary policy response (Ehrmann & Fratzscher,
2004). For investment, a firm can raise funds either internally with the help of existing cashflows or
externally through bank loans or capital markets. The tampering of monetary policy has a robust
effect on bank-dependent firms. Monetary tightening reduces the supply of bank loans, and loans
and nonbank sources of finance try to substitute the bank loan. The firms that make an investment
without approaching the public debt markets face considerable liquidity-constrain, whereas the
bank-dependent firms neither have accessibility to bond market nor have internal cash reserves;
hence, they have to considerably reduce investment during the monetary contraction period in
comparison to their nonbank-dependent counterparts. Similarly, firms with large cashflows need
to be resistant to alterations in the interest rates because they are capable of depending on their
internal source of finance for making investment.
The heterogeneity of the response of stock prices to monetary policy also varies with firm size.
The imperfect capital market theory predicts that the risk associated with small and large firms
can be affected in different ways owing to change in the credit market conditions (Benanke &
Gertler, 1989; Kiyotaki & Moore, 1997). For small firms, the reaction of stock returns in relation to
monetary policy is higher (Thorbecke, 1997). Further, small firms demonstrate the highest degree
of asymmetry in relation to the risk associated with recession and expansion states that trans-
forms into higher sensitivity of their expected stock returns concerning those variables, which
determine the condition of credit market (Fama & French, 1995; Perez-Quiros & Timmermann,
2000). In comparison to big stocks, the small stocks also have reduced income on book equity.
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However, with regard to the small firms, the results obtained though indicative are not conclud-
ing, as there is no correlation between size and financial constraints. Many researchers have
provided evidence against the impact of firm size (Arnold & Vrugt, 2004; Carlino & DeFina, 1998;
Mojon, Smets, & Vermeulen, 2002). Moreover, in comparison to other measures, size cannot be
considered as a good proxy for financial constraints. While firms in the constrained category are
smaller than firms in the non-constrained category, size is not the dominant factor behind
categorizing firms under the constraint category (Fazzari, Hubbard, Petersen, Blinder, & Poterba,
1988). Lamont, Polk, and Saaá-Requejo (2001) found that during 1968–1997 firms having financial
limitation display certain co-movements in the form of stock returns, and it is not attributable to
firm size or other factors like industry-specific effects.
The heterogeneity of the impact of monetary policy on the returns of the stock market comes not
only from firms but also from the industries. For example, if monetary policy affects exchange rates,
then there will probably be more impact on the industries involved in trading. For the capital-
intensive industries, the changes made by the monetary policy related to the cost of capital play
a very crucial role. Hence, it is implied that the impact on the predicted future earnings across
industries is heterogeneous in nature, which is reflected through the changes in stock returns.
Therefore, firms in the cyclical industries, capital-intensive industries, and industries that are rela-
tively open to trade will probably be fervently affected (Ehrmann & Fratzscher, 2004). The natural
question is whether the responses are consistent with the CAPM model. Bernanke and Kuttner (2005)
concluded that one-factor CAPM provides a good explanation of the variation prevalent in the
observed industry. With data from five OECD countries, Dedola and Lippi (2005) recognized the
impact of monetary policy in relation to the cross-industry heterogeneity and associated it with the
distinctive features of an industry, as recommended by the monetary transmission theories.
Moreover, there are considerable and noteworthy differences in the ways monetary policies
impacted. The sectoral output responses to monetary policy shocks are thoroughly associated
with the stability of industry output, financial obligation, borrowing ability, and firm size. Similarly,
Ganley and Salmon (1997) and Hayo and Uhlenbrock (2000) analyzed the industrial outcomes in the
United Kingdom and Germany. Angeloni and Ehrmann (2003) analyzed the cross-sectional
responses associated with the returns of the stock market regarding monetary policy in the euro-
zone, and Bernanke and Kuttner (2005) performed a similar analysis in the US. The evidence related
to India indicates that the differential response is primarily based on the variations of firm size and
usage of working capital along with the percentage of interest cost. Hence, as per the financial
accelerator and interest rate mechanisms, there is a presumed significance behind the reasons for
a monetary policy having more impact on specific industries in India (Ghosh, 2009).
While many studies have been conducted on the impact of monetary policy on the stock market
at the country level, only few studies have documented the relationship between stock market
returns and other macroeconomic variables. Maysami et al. (2005) analyzed the presence of
a long-standing and stable relationship between the selected macroeconomic variables and the
Singapore stock market index. He further scrutinized the relationship with various Singapore
Exchange Sector indices—the finance index, the property index, and the hotel index. The study
further deduced that there is a cointegrating relationship of the Singapore’s stock market and the
property index with the temporary as well as continuous alterations in the interest rates, industrial
manufacturing, costs, exchange rate, and money supply. Ewing (2002) analyzed the innovations
made for numerous fundamental macroeconomic variables, which are conveyed through the
functioning of financial sector stock returns, specifically, the NASDAQ Financial 100 index. The
stock returns of financial companies are related to macroeconomic factors; the relationship was
scrutinized by calculating the functions associated with the generalized impulse response, which is
obtained by determining the vector autoregression model. Gupta and Reid (2013) analyzed the
sensitiveness of diverse South African stock indices in relation to the unpredictable movements of
macroeconomic indicators such as monetary policy and the CPI. He further examined the instan-
taneous effect of macroeconomic shocks on a variety of stock market indices, which was pursued
by a Bayesian vector autoregressive analysis that imparted insights about the vibrant impact of
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shocks on the stock market indices. Kyereboah-Coleman and Agyire-Tettey (2008) examined the
ways in which the macroeconomic indicators affect the Ghana Stock Exchange and concluded that
the lending rates from deposit money banks and inflation adversely affect the stock market
performance. In contrast to the general expectation, the loss in exchange rate does not affect
equities, and the depreciation of the domestic currency is beneficial for investors.
3. Methodology and data

The financial markets incorporate information in advance, and therefore, the stock price must have
already captured the expected macroeconomic information. Nevertheless, the stock price must
adjust with the unanticipated or surprise factor depending on its substantiation. Moreover, the
surprise element related to macroeconomy eliminates any endogenous matter that initiates from
the market information, as the predictable effects are integrated into the expected component of
macroeconomic data (Gürkaynak, Levin, & Swanson, 2010).
The surprise is defined as the actual data minus forecast data; thus,
Surprise ¼ Actual data Forecast data
Surprise can be categorized into two parts; one is the macroeconomic surprise, and the other is the
monetary policy surprise.
For macroeconomic surprise, the forecast data are the median forecast from the survey of
a panel of professional forecasters. Bloomberg captures the professional forecast and updates it
prior to the release of actual data. The actual data released on a particular date for macroeco-
nomic indicators are the data of the previous period; hence, they are lag indicators.
The macroeconomic indicators considered for our study are GDP, WPI, CPI, Index of Industrial
Production (IIP), and Current Account Deficit (CAD). The choice of these indicators is consistent
with other literature (Bernanke & Kuttner, 2005; Gupta & Reid, 2013). Further, through
a professional survey, Bloomberg predicted these macroeconomic economic indicators.
Contrary to the other macroeconomic variables, the market data are used for constructing the
monetary policy surprise. The actual market data for monetary policy is forward indicators. However,
the policy actions are not precisely visible as expected in the context of the market. In the US, there are
tradable instruments—Fed Funds futures. The futures prices are the usual market-based proxy for the
expectations. The forecasts of funds’ rate as per the futures price are “efficient” because there is no
considerable correlation between the forecast errors and other variables while pricing the contract
(Krueger & Kuttner, 1996). Therefore, for the monetary policy, the majority of the studies in the US
employ the data of federal funds futures for obtaining the surprise element of policy announcements.
Unfortunately, no such information for India is obtainable. The 91-day T-bill yield in the secondary
market is the closest proxy for encapsulating the surprise factor due to any monetary policy action
by the RBI. The other alternative could have been 90 days MIBOR rate (Mumbai Interbank Offer
Rate), but MIBOR is more for liquidity management, which is not a true reflection of the policy action.
For estimating the sensitiveness of stock returns to monetary policy and macroeconomic surprises, we
considered 20 indices. These indices are chosen as per the research objectives, viz., (a) Benchmark
Indices, which is relevant to understand the response of overall stock market—BSE SENSEX (30 large
well-established companies, which are the representative of various sectors of Indian economy and
whose stocks are well traded) and NIFTY 50 (50 Indian company stocks in 12 sectors). The BSE Sensex
and NIFTY 50 are also used as a proxy for the large-sized firms. The other sets of indices used for
assessing the overall response of stock market are NIFTY 200 (a set of 200 companies representing 85%
of free float market capitalization of NSE) and NIFTY 500 (a set of 500 companies representing 95% of
free float market capitalization of NSE). (b) Sectoral Indices, which will be relevant to understand the
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industry-specific response—NIFTY Energy (Energy sector), NIFTY Infra (Infrastructure sector), NIFTY PSU
BANKS (Public sector banking sector), BSE BANKEX (Banking sector), BSE Auto (Automobile sector), BSE
Capital Goods (Capital Goods sector), BSE Consumer Durables (Consumer durable sector), BSE Fast
Moving Consumer Durables (Fast moving consumer durable sector), BSE Health (Health sector), BSE IT
(Information Technology sector), and BSE Metal (Metal sector). The Indian financial sector being depen-
dent on the banking sector, the bank indices are also considered to understand industry effect. (c) Size-
specific indices to understand size effect—BSE Midcap, NIFTY 100 Midcap, and NIFY 50 Midcap (repre-
sentative of medium-sized firm), BSE Small Cap and NIFTY 100 Smallcap (representative of the small-
sized firm), along with BSE Sensex and NIFTY 50, which are the representative of large-sized firms. In our
size effect analysis, we considered market capitalization as the measure of firm size.
The data considered for the study were from 1 April 2004 to 31 July 2016. The macroeconomic
and monetary policy release dates were taken from the Bloomberg and RBI website and were
further validated through the FT Calendar. The data for macroeconomic indicators, monetary
policy, forecast parameters, and the indices were gathered from Bloomberg. The patterns of
Actual, Forecast, and Surprise factors of macroeconomic indicators are depicted in Figures 1–5.
The surprises factors are plotted on the right-hand axis of each of these graphs, while the basic
series are plotted on the left-hand axis. The surprise is the difference between actual data minus
forecast data; and therefore, all surprises are in percentage-point, except CAD surprise, which is
expressed in USD billion. From GDP surprises (Figure 1), it is clear that both the positive and
negative surprises are equally probable, though the magnitudes of positive surprises are generally
more than the negative one for this period. The number of positive surprises is more in WPI,
whereas the number of negative and positive surprises is almost same for CPI (Figures 2 and 3:
WPI and CPI surprises). The IIP surprise data show more positive surprises than negative, though
the maximum magnitude of surprises in each direction is almost same (Figure 4), and the number
of positive and negative surprises is almost equal in the case of CAD surprises (Figure 5).
Every monetary policy actions—any decisions on bank rate, liquidity adjustment facility, Repo/
Reverse Repo action, CRR (Cash Reserve Ratio), SLR (Statutory Liquidity Ratio), and MSF (Marginal
Standing Facility)—are considered as the monetary policy announcement event. In the last 12
years, the frequency of monetary policy action changed significantly. For instance, from 2005,
a half-yearly policy shifted to a quarterly schedule; the RBI started the mid-quarter policy
Figure 1. GDP surprise. GDP Surprise
Surprise (% point)
10.00% 4.00%
GDP (%)
2.00%
5.00%
0.00%
0.00% -2.00%
May-05 Oct-06 Feb-08 Jul-09 Nov-10 Apr-12 Aug-13 Dec-14 May-16 Sep-17
Actual Forecast Surprise
Figure 2. WPI surprise. WPI Surprise

15.00% 1.00%
Surprise(% point)
10.00%
0.00%
WPI (%)
5.00%
-1.00%
0.00%
-5.00% Jul-09 Nov-10 Apr-12 Aug-13 Dec-14 May-16 Sep-17 -2.00%
-10.00% -3.00%
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Figure 3. CPI surprise. CPI Suprise

12.00% 2.00%
Surprise (% point )
10.00% 1.50%
8.00% 1.00%
CPI (%)
6.00% 0.50%
4.00% 0.00%
2.00% -0.50%
0.00% -1.00%
Nov-12
Nov-13
Nov-14
Jul-12
Sep-12
Mar-13
May-13
Jul-13
May-14
Nov-15
Sep-13
Mar-14
Jul-14
Sep-14
Mar-15
May-15
Jul-15
Sep-15
Jan-13
Mar-16
May-16
Jan-14
Jan-15
Jan-16
Figure 4. IIP surprise. IIP surprise

20.00% 10.00%
Surprise (% point)
15.00%
5.00%
IIP Data (%)
10.00%
5.00% 0.00%
0.00%
-5.00%
-5.00% May-05 Oct-06 Feb-08 Jul-09 Nov-10 Apr-12 Aug-13 Dec-14 May-16 Sep-17
-10.00% -10.00%
Figure 5. CAD surprise. CAD Surprise

10.00 12.00
10.00
Surprise (Bn USD)

0.00
8.00
CAD (Bn USD)
Apr-12 Oct-12 May-13 Nov-13 Jun-14 Dec-14 Jul-15 Jan-16 Aug-16 Mar-17
-10.00 6.00
4.00
-20.00 2.00
0.00
-30.00
-2.00
-40.00 -4.00
Figure 6. Monetary policy Monetary policy surprise

surprise.
12.00% 2.00%
91 days T-bill rate (%)
Surprise (% points)
10.00% 1.50%
8.00% 1.00%
6.00% 0.50%
4.00% 0.00%
2.00% -0.50%
0.00% -1.00%
Sep-02 Jan-04 May-05 Oct-06 Feb-08 Jul-09 Nov-10 Apr-12 Aug-13 Dec-14 May-16 Sep-17
91 days -Tbill rate Surprise
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announcements from 2011. Moreover, there were also non-scheduled policy announcements.
From 1 April 2004 to 31 July 2016, a total of 86 policy announcements have been made, of
which 63 were scheduled and 23 were unscheduled. The difference between 91-day T-bill yield
both after and before the announcement is the monetary policy surprise. The monetary policy
surprise is indicated in Figure 6. The right-hand axis is surprise in percentage point, and the left-
hand side is T-bill. The monetary policy surprises have almost equal representation of both the
positive and negative surprises in this sample period.
4. Event study and findings

According to the empirical literature, the policy and stock market relationship can be understood
with the help of three broad methodologies. First, the event-based studies consider the chronolo-
gical changes in stock price for making any declaration related to policy changes. Second, the VAR
framework comprises few policy indicators, stock prices, and few related variables; and third, the
heteroscedasticity is based on the Generalized Method of Moments.
The fundamental limitation of any of these methodologies is the endogeneity bias, i.e., the
extraction of policy shocks or surprises from models or the changes in the economic variables
utilizing the monthly or quarterly frequencies will not probably be absolutely exogenous. Any policy
actions have certain economic impacts, but the isolation of these effects is not simple because the
policy actions are dependent on the status of the economy. The response of economic variables to
the reactive actions of policymakers reflects the collective impacts of the policy action and the
variables that affect the policy. For isolating the impacts of policy actions, it is vital to ascertain the
non-reactive element of the policy, i.e., the exogenous factor in relation to other variables
(Christiano, Eichenbaum, & Evans, 1996).
Therefore, the dynamism associated with the short-term interest rate and asset prices are
it ¼ βst þ θxt þ γzt þ εt (1)
st ¼ αit þ φxt þ δzt þ ηt (2)
where it is the three-month rate of Treasury bill and st is the daily stock return. The variables xt and
zt represent the macroeconomic shocks or surprises, which probably affect the stock prices and
interest rates. The macroeconomic indicators considered for analysis satisfy this criterion.
Our focus is on the short-horizon event study, which focuses on the momentary change,
and the implicit assumption is that the change in stock price is related to the event only. The
other stock market prediction model such as Fama–French is appropriate for long-horizon
event studies, where appropriate adjustment for risk, aggregation of security-specific abnor-
mal return, etc., become critically important. This is in sharp contrast to the short-horizon
tests in which those adjustments are straightforward and typically unimportant (Khothari &
Warner, 2006).
Therefore, in the event study approach, Equation (2) is only estimated, and the stock price
changes are immediately utilized after the realization of the surprise element. There is an implicit
assumption that within the limit, the variance of the shock caused by factors under consideration
becomes substantially large in comparison to the variance of other shocks as has been on the
announcement dates. Controlling the effect of endogeneity on the regression results is a challenge
confronted by this type of analysis. To isolate the effect of a particular shock, it is preferable to use
a small window period because there is less probability of encountering more than one macro
shock, and thus, it facilitates in establishing the correlation between the specific shock and the
stock indexes during the small phase.
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For precise identification of policy shocks, much research on event studies has been carried out
on the basis of higher-frequency observations—generally daily data—for analyzing the reaction of
the equity market in relation to policy announcement. Keeping consistency with the efficient
market hypothesis, it is observed that on the announcement day, markets do not react much on
the announcements made; rather the reaction is more toward the unexpected (surprise) compo-
nent, which has not yet been factored in the market price (Kuttner, 2001).
Another alternative to the daily data could be intraday data. With the use of intraday data in
a comparatively narrow “event window”, the actual announcement can differentiate the influence
of change in policy depending on the early or late incoming of news on a day. Through the
application of narrow window with the intraday trading data, Gürkaynak, Sack, and Swansonc
(2005b) depicted that the response of equity price is effectively identical to the response obtained
through the daily data, as done by Bernanke and Kuttner (2005), though the intraday data resulted
in an improvement in the R2. However, the decision in favor of broader event window is that it
avoids spurious data and hence is a balanced approach (Ehrmann & Fratzscher, 2004).
We conducted the event study by following the methodology of Bernanke and Kuttner (2005).
The daily data were employed to segregate the effect of the surprise that the market experience
with the release of macroeconomic data or declaration of monetary policy.
For the event study, we considered only the relevant data sets that are affected by the event.
Here, the event is the surprise, which happened when monetary policy or macroeconomic variables
are announced. Hence, for each macroeconomic variable and monetary policy, surprise (actual vs.
expected) is recognized only on those relevant dates, and on other dates, it is zero. Therefore, this
event study data set constitutes 358 observations.
Following the approach employed in Bernanke and Kuttner (2005), we conducted 17 regressions
with one stock index at a time, and in each case, the dependent variable was the stock returns. We
calculated the stock return as the first differences of the log-levels of the stock indices in
percentages; thus,
Stock return ¼ ln ðStþ1 Þ lnðSt Þ (3)
where Stþ1 is stock indices in day ðt þ 1Þ, and St is stock indices in day t:
The log of the stock return was regressed with the surprise component of macroeconomic and
monetary policy parameters.
Stock return ¼ Constant þ β1 GDPsurprise þ β2 IIPsurprise þ β3 WPIsurprise þ β4 CPIsurprise

þ β5 CADsurprise þ β6 Monetary policysurprise (4)
For normalizing these macroeconomic surprise variables, each series of these variables were
divided by its standard error. Through this process, it becomes easy to interpret the regression
coefficients as the effect of one-standard-error-surprise in that release (Gürkaynak, Sack, &
Swanson, 2005a). However, the monetary policy surprise derived from 91-day T-bill was not
normalized as it was possible to interpret the data.
The results of the event study are presented in Table 1. The results signify that the effect of
domestic monetary policy surprises on stock indices controls all the other macroeconomic
surprises. The negative relationship between monetary policy surprises and stock returns is
the theoretical expectation, and depending on the expectation, it is observed that the coeffi-
cients of monetary policy are negative and statistically significant for all indices. The surprise in
monetary policy of 100 basis points changes the stock market returns represented by various
indices from 1.4% to 3.8%, significant at 1% level, which is similar to the findings of Bernanke
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Table 1. Result of event study
Index C Monetary_Policy_Surprise GDP_Surprise WPI_Surprise CPI_Surprise IIP_Surprise CAD_Surprise R2
https://doi.org/10.1080/23322039.2019.1598248
Nifty 50 Coefficient 0.001294 −2.876292 0.009043 −0.003995 −0.020843 −0.004245 0.015835 0.032461
P value 0.1861 0.0009 0.9181 0.8604 0.5637 0.7737 0.8818
Nifty 200 Coefficient 0.00095 −2.619555 −0.002295 −0.010379 −0.012867 −0.004205 0.039802 0.034456
P value 0.2792 0.0007 0.9767 0.6094 0.6902 0.7508 0.676
NIFTY 500 Coefficient 0.000926 −2.56107 −0.002792 −0.009142 −0.011838 −0.004502 0.03596 0.033883
P value 0.2836 0.0008 0.9712 0.6471 0.7091 0.7295 0.7009
NIFTY 50 Midcap Coefficient 0.001352 −2.86406 −0.00073 −0.00919 −0.03101 −0.00163 0.05675 0.031259
P value 0.191 0.0017 0.9938 0.7007 0.4145 0.9165 0.6127
NIFTY 100 Midcap Coefficient 0.001266 −2.39327 −0.0078 −0.00287 −0.01636 −0.00317 0.017419 0.0306
P value 0.140982 0.001451 0.918613 0.884002 0.601192 0.804824 0.850406
NIFTY 100 Smallcap Coefficient −0.00169 −4.19559 0.032441 −0.0104 0.002662 −0.01504 0.105427 0.046867
P value 0.058545 0.020458 0.695999 0.560288 0.910236 0.289618 0.130502
NIFTY_Energy Coefficient 0.000714 −2.579615 −5.43E-03 −7.76E-03 −2.22E-03 5.95E-03 0.059602 0.027454
P value 0.465 0.0027 0.9506 0.7315 0.9507 0.6864 0.574
NIFTY_Infra Coefficient 0.000993 −3.130476 −0.037631 −5.07E-03 −0.016139 −3.74E-03 0.078741 0.034112
P value 0.3534 0.0009 0.694 0.8372 0.6807 0.8162 0.4963
NIFTY_PSU Bank Coefficient 0.000735 −2.184582 0.022329 −0.034119 −0.081052 −0.013093 0.002797 0.021574
P value 0.5936 0.0701 0.8561 0.2877 0.1092 0.5283 0.985
BSE Sensex Coefficient 0.00082 −2.7112 −0.016499 −0.010555 −1.11E-02 −0.004791 0.046076 0.03754
P value 0.3407 0.0004 0.8315 0.5982 0.7264 0.7122 0.6237
BSE Midcap Coefficient 0.001096 −2.087223 0.011081 2.04E-03 −0.017097 −5.17E-03 0.027696 0.024454
P value 0.187 0.0045 0.8822 0.916 0.5774 0.68 0.7597
BSE Smallcap Coefficient 0.000973 −1.81282 0.013548 0.011322 −0.009977 −0.007846 −0.010483 0.019723
P value 0.2407 0.0135 0.8561 0.5574 0.7448 0.5306 0.9077
(Continued)
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Table 1. (Continued)
Index C Monetary_Policy_Surprise GDP_Surprise WPI_Surprise CPI_Surprise IIP_Surprise CAD_Surprise R2
https://doi.org/10.1080/23322039.2019.1598248
BSE Auto Coefficient 0.001616 −2.303724 −0.000232 0.002526 −0.008305 0.002124 0.103052 0.025841
P value 0.0795 0.0047 0.9978 0.9061 0.8071 0.8784 0.3049
BSE Bankex Coefficient 0.000699 −2.408053 0.106851 −0.032847 −4.47E-02 −0.00524 0.059641 0.026627
P value 0.5471 0.019 0.3073 0.2245 0.2977 0.7649 0.6378
BSE Capital Goods Coefficient 0.000981 −2.840587 −0.072901 −0.00353 −0.031476 −0.008703 0.114373 0.029836
P value 0.3772 0.0039 0.4663 0.8914 0.4434 0.6036 0.3455
BSE_Consumer Durables Coefficient 0.00057 −2.23776 −0.084899 −1.85E-02 −0.015854 0.001951 0.046583 0.021498
P value 0.5857 0.0157 0.3682 0.4479 0.682 0.9017 0.6834
BSE_Fast Moving Consumer Coefficient 0.000947 −1.419826 −1.83E-01 −5.61E-03 −0.006659 −0.007815 −0.035189 0.037834
durable
P value 0.1905 0.0263 0.0053 0.7389 0.8032 0.4739 0.6556
BSE_Health Coefficient 0.000993 −1.632766 8.41E-02 1.02E-02 −6.73E-03 −0.007069 0.003027 0.031551
P value 0.1245 0.0043 0.1486 0.4986 0.778 0.4682 0.9657
BSE_IT Coefficient 0.000839 −2.20899 −2.66E-02 −0.021973 9.00E-03 −0.031068 0.004236 0.035645
P value 0.3724 0.008 0.7534 0.3156 0.7957 0.0291 0.9671
BSE_Metal Coefficient 0.001891 −3.824946 −0.019053 −0.000723 0.000245 −0.014285 0.09753 0.034621
P value 0.1403 0.0008 0.8688 0.9806 0.9959 0.4599 0.4852
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and Kuttner (2005), Rigobon and Sack (2003), and Ehrmann and Fratzscher (2004) related to
the US stocks.
The coefficients of the other macroeconomic surprises are found to be strongly insignificant,
which is in line with the low effect size of each surprise variable. This result is consistent with
other studies conducted in different countries, for example, South Africa (Gupta & Reid, 2013).
According to the literature of other economy, few of the possible explanations of this result are
investor’s interpretation of macroeconomic surprises and risk (Chen, Roll, & Ross, 1986;
McQueen & Rolewy, 1993; Pearce & Roley, 1985), quality of the data and announcement
(Gilbert, Scotti, Strasser, & Vega, 2010), time lag between the reference period and the
announcement release time (Gilbert, Scotti, Strasser, & Vega, 2017), and market adjustment
in the next trading day (Pearce & Roley, 1983). There are two other possibilities in the Indian
context. First, during the study period, the uncertainty associated with the Indian macroeco-
nomic fundamentals was rather low owing to the functioning of its well-regulated financial
system. In this relatively stable microenvironment, the extent of surprises was low. Second, the
Indian stock market is well integrated with active participation of FPIs and FIIs investment, and
many of the stock market reactions may not be governed by domestic macroeconomic sur-
prises, rather it depends on global developments. We tend to believe more on India-specific
reasons for low effect size of surprise variable.
The stock price movement is dependent on many factors other than those defined in the model
as surprises, and therefore, it is expected that the overall R2 value will be low. The low R2 means
that very little of stock price variance can be explained with macroeconomic surprises; however,
the range of R2 value is consistent with the observations of Bernanke and Kuttner (2005).
Industry effect is observed in the event study. The capital-intensive sectors, for instance, the
infrastructure sector and capital goods, are more sensitive to monetary policy surprise as char-
acterized by a higher coefficient of monetary policy than NIFTY200. The sectors that are more
vulnerable to the economic cycle and are relatively open to international trade—for instance,
Metal has a higher coefficient of monetary policy—will be affected more strongly by monetary
policy surprise. Contrary to this, the recession-proof sectors such as healthcare or fast-moving
consumer durables demonstrate lowercoefficient of monetary policy.
According to the prediction of the imperfect capital market theory, the alterations in the credit
market conditions can differently affect the small and large firms. We observed the responses of stock
returns of the large-sized firms through BSE Sensex, the medium-sized firms through BSE Midcap, and
the small-sized firms through BSE Smallcap. We found that the responses of stock return to monetary
policy are different for large, medium, and small firms as depicted through their coefficients. The
sensitivities of stock return to monetary policy are maximum for a large firm, which is followed by the
medium-sized firm and subsequently by the small firm. The result is consistent for NSE Indices also
(NIFTY 50 proxy for large firms, and NIFTY 50 Midcap and NIFTY 100 Midcap are the proxies for
medium-sized firms), except the small firms that are represented by NSE 100 SmallCap, which
shows increased sensitivity. However, this finding is quantitatively different from the observations
made by Thorbecke (1997), Kiyotaki and Moore (1997), Perez-Quiros and Timmermann (2000), etc., as
in those studies, it has been shown that the response of stock returns to monetary policy is larger for
small firms. The reason for the higher sensitivity of smaller firms in those studies is the higher degree of
risk associated with smaller firms with the change in the credit market conditions during the reces-
sionary or expansionary economy. For our study, this is not the case, as there is no correlation between
firm size—which is represented by various indices—and the financial constraints. Moreover, upon
using the different indices as the proxy for size, the industry effect dominates the size effect.
5. VAR analysis and findings

The event study based on the equity return with respect to the surprise element does not address
the dynamic relationship; however, we are also interested in understanding the dynamic
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relationships of all macroeconomic surprises on stock prices and their heterogeneity, which can be
captured through a VAR model.
Many VAR models were used for evaluating the effect of monetary policy on various parts
of the economy by focusing on an unanticipated element of the action. Kim (2001) using the
VAR model evidenced international transmission of the US monetary policy shocks. In the
VAR model, Canova (2005) treated the US shocks as exogenous in relation to the Latin
American economies and focused on the transmission of the US shocks to eight Latin
American countries. Miniane and Rogers (2007) analyzed the ways through which the
exchange rate and foreign country interest rates are influenced by the identified US monetary
shocks and treated the US variables as exogenous. Goto and Valkanov (2000) employed
a VAR-based method focusing on the covariance between inflation and stock returns.
Campbell (1991) and Campbell and Ammer (1993) tried to understand the factors responsible
for excess return in long-term assets and utilized the VAR technique to calculate revisions in
expectations of the key variables, viz., future interest rates, dividends, and excess returns. In
their study, by extending the Campbell–Ammer (Campbell & Ammer, 1993) model, Bernanke
and Kuttner (2005) employed a VAR methodology to obtain proxies for the relevant expecta-
tions and derived the surprise component of monetary policy from federal fund futures.
Patelis (1997) also used the Campbell–Ammer framework for variance decomposition to
find how monetary policy affects the components of excess return but derived the policy
shocks from the identified VAR itself.
A VAR model constituting of shocks associated with the predictor variables, viz., dividend yield,
term spread, default spread, and Treasury-bill yield, is capable of explaining the average return
better than the Fama–French model (Petkova, 2006). Further, Campbell (1996) argued that parsi-
mony is particularly important for a VAR model and the default spread can be omitted, as it has no
marginal explanatory power for stock returns if the dividend yield is included in the system. The
work of Bernanke and Kuttner (2005), which is actually an extension of the framework of
Campbell–Ammer (Campbell & Ammer, 1993), uses all these relevant predictive variables, viz.,
dividend yield, term spread, and Treasury-bill yield, and is an efficient VAR framework.
Realistically, like many of the economic analysis focusing on economic shocks, in our analysis
also, the surprises are treated as exogenous variables. But, in the classical VAR model, if the
surprises are treated as exogenous variables, it is difficult to obtain impulse responses by changing
these surprise variables. The Bernanke and Kuttner (2005) methodology allows us to do that.
We adopted the VAR model proposed by Bernanke and Kuttner (2005) and extended it further.
We augmented their VAR model with both monetary policy and other macroeconomic surprises.
This allowed us to separate the unanticipated elements of the monetary policy variable and other
macroeconomic indicators. We further tested the heterogeneity of stock response at industry level
and firm level (size effect) with this VAR approach.
Bernanke and Kuttner's (2005) VAR model is an extension of Campbell–Ammer (Campbell &
Ammer, 1993) model. Campbell–Ammer method used a log-linear approximation to decompose
the excess equity returns into components attributable to news about real interest rates, divi-
dends, and future excess returns and subsequently employed a VAR methodology to obtain
proxies for the relevant expectations. Bernanke and Kuttner (2005) took this further by relating
the proxies for expectations to the surprises on monetary policy from the Federal funds futures,
which permitted them to calculate the effect of federal funds surprises on the expected future
dividends, real interest rates, and expected future excess returns.
ytþ1 ¼ log ðExcess return of equityÞ

¼ Total return on equity ði:e: Price change þ DividendÞ
The risk free rate ð3 month Treasury bill rateÞ:
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The ytþ1 represents the log of excess return on a stock kept from the beginning of the period t to
the beginning of the period t þ 1, and it is measured relative to the return on short debt.
y
Let etþ1 = unexpected excess return = ytþ1 Et ytþ1 ; Et is the expectation formed in the begin-
ning of the period t.
The basic equation of stock returns relates the unexpected excess return in time t þ 1 to
changes in rational expectations of future dividend growth, future real interest rates, and future
excess stock returns. The dtþ1 is the log real dividend paid during the period t þ 1, and rtþ1 is the
log real interest rate from t to t þ 1
!
j¼1 j¼1 j¼1
y
etþ1 ¼ ytþ1 Et ytþ1 ¼ ðEtþ1 Et Þ ∑ ρj Δdtþ1þj ∑ ρj rtþ1þj ∑ ρj ytþ1þj (5)
j¼0 j¼0 j¼1
while Δ indicates one-period backward difference and the discount factor ρ comes out from the
process of log-linear approximation (linearization) and is representative of the steady-state ratio of
the equity price to the price plus dividend, and it is a number smaller than 1 (0.9962) (Campbell &
Ammer, 1993).
Equation (5) shows that in case the unexpected excess return is negative, then either the
expected future dividend growth is lower or the expected future real stock returns is higher or
both.
Equation (5) can be rewritten with simplified notation as

,y
etþ1 ¼ e,d ,r
y
tþ1 etþ1 etþ1 (6)
where the “e”s represent the revision in expectation between periods t and t þ 1, and the tilde
denotes a discounted sum so that,
e,d
j¼1
tþ1 ¼ ðEtþ1 Et Þ ∑j¼0 ρ Δdtþ1þj
j
(6a)
e,r
j¼1
tþ1 ¼ ðEtþ1 Et Þ ∑j¼0 ρ rtþ1þj
j
(6b)
,y j¼1
etþ1 ¼ ðEtþ1 Et Þ ∑j¼1 ρj ytþ1þj (6c)
The implementation of this decomposition needs empirical proxies for the expectations appearing
in Equation (6). Campbell and Ammer (1993) modeled this using the VAR approach on the basis of
the assumption that it is possible to present the unobserved components of returns as linear
combinations of innovations or surprises associated with the observable variables. With the use of
a time-series model, the coefficients of these linear combinations are estimated and used for
constructing forecast related to the discounted value of future dividends, real interest rates, excess
returns, etc. The revisions of these forecasts are subsequently employed as proxies for the revi-
sions in investors’ expectations.
In the stock market, the long-term asset prices are used as the forecasting variables and the log
dividend–price ratio or dividend yield satisfies the following equation
j¼1
dt pt ¼ Et ∑j¼0 ρj ½Δdtþ1þj þ rtþ1þj þ ytþ1þj (7)
The third term on the right-hand side, ytþ1þj , is the long-horizon excess return. Therefore, if the first
two terms (Δdtþ1þj and rtþ1þj Þ on the right-hand side are considered as stationary, the dividend–
price ratio acts as a proxy for the long-horizon expected excess return.
Let,
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rt is the real interest rate, which is calculated as the difference between one-month bill yield and
the log difference in the non-seasonally adjusted CPI.
xn;tþ1 is the log excess one-period return of n-period zero coupon bond held from time t to time ðt þ 1).
ðnÞ
pt is the log price of n-year discount bond at time t.
ð nÞ
pt
kn;t is the nominal log yield to maturity, which is n because, at the maturity, bond price is
ð0Þ
unity, and hence, ptþn ¼0
Δk1;t is the change in the nominal interest rate.
sn;t is the difference or yield spread between n period nominal interest rate and the one-period
nominal interest rate, i.e., kn;t –k1;t . The yield spread between the interest rates of the two different
maturities is to eliminate unit root in the nominal interest rate (Campbell, 1991).
Campbell and Ammer (1993) considered another parameter, the relative bill rate, which is the
difference between T-bill rate and one-year backward moving average. The inclusion of these
short-term interest rates improves the forecasting power of stock return.
Therefore, the relative bill rate is defined as,
1 i¼12 i
rbt ¼ k1t ∑ k1;ti ¼ ∑i¼12
i¼0 ð1 ÞΔk1;ti (8)
12 i¼1 12
With these, Campbell and Ammer (1993) defined the state vector, zt , where
0 1
yt
B rt C
B C
B Δk1;t C
zt ¼ B
B sn;t C
C (9)
B C
@ dt pt A
rbt
If the state vector follows the first-order VAR process, then the VAR equation becomes
ztþ1 ¼ Azt þ wtþ1 (10)
where ztþ1 is np 1 matrix, A is the np np coefficient matrix, and w is a sequence of a serially

uncorrelated random np 1matrix.
For this VAR equation, Campbell and Ammer (1993) wrote the solution as
y
etþ1 ¼ sy wtþ1 (11)
,y
etþ1 ¼ sy ρAðI ρAÞ1 wtþ1 (12)
1
e,r
tþ1 ¼ sr ðI ρAÞ wtþ1 (13)
,y
e,d ,r
y
tþ1 ¼ etþ1 þ etþ1 þ etþ1 (14)
where sy and sr are appropriate 1 np selection matrix.
The VAR equation (Equation 10) proposed by Campbell and Ammer (1993) was further modified
by Bernanke and Kuttner (2005) by introducing monetary policy surprise as the contemporaneous
exogeneous variables in Equation (10)
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?
ztþ1 ¼ Azt þ iu tþ1 þ ftþ1 (15)
where iu is the monetary policy surprise. is 1 n matrix that captures the contemporaneous response
?
of ztþ1 to the monetary policy surprise factors in the period ðt þ 1Þ, and ftþ1 is orthogonal to monetary
policy surprises. The error associated with the VAR’s 1-month-ahead forecast (wtþ1 Þ is efficiently broken
into a component, which is related to the monetary policy surprises, iu tþ1 , and a component other than
?
the monetary surprises, ftþ1 . Because iu tþ1 is the forecast error at time t, it is orthogonal to zt . Therefore,
both A and can be estimated through VAR estimators. The incorporation of the monetary policy
surprise into the VAR allows the extraction of an orthogonal element iu tþ1 from (wtþ1 Þ forecast error,
and this is used to estimate the impulse responses of the variables in VAR to the orthogonal component.
For Equation (15), the unexpected excess return can be rewritten as

y ?

etþ1 ¼ sy wtþ1 ¼ sy iu tþ1 þ ftþ1 (16)
Thus, the instantaneous response of unexpected excess return to the 1-percentage-point surprise
increase is sy . For longer window, they estimated the impulse response through multiplier
analysis. In that analysis, if it is assumed that unit shock happens in period t ¼ 0 and no further
shocks happen in subsequent period, in general, the increase of k-month response to
a 1-percentage-point surprise increase can be written as Ak .
In our model, we extended Bernanke and Kuttner (2005) methodology for other macroeconomic
surprises. We constructed the VAR model for all six surprises and added five macroeconomic
surprises with the monetary policy surprise and created the Macroeconomic Surprise Vector.
Therefore, Equation (15) in our model is modified further as
ztþ1 ¼ Azt þ φxtþ1 þ w?

tþ1 (17)
where xtþ1 is the Macroeconomic Surprise Vector that captures all the macroeconomic surprises.
φ is 1 n matrix that captures the exogenous response of ztþ1 to the macroeconomic policy
surprises and w?tþ1 is the orthogonal component. Because xtþ1 is the normal forecast error of
macroeconomic factors at time t, it is orthogonal to zt . Therefore, both A and φ can be estimated
through VAR estimators, as done by Bernanke and Kuttner (2005) in their monetary policy model.
So, for Equation (17), the unexpected excess return in our model can be rewritten as,

etþ1 ¼ sy wtþ1 ¼ sy φxtþ1 þ w?
y
tþ1 (18)
Here also, the impulse response can be estimated through multiplier analysis. If we assume that
unit shock happens for a particular exogenous variable in period t ¼ 0 and no further shocks
happen in subsequent period, the increase of k-month response to a 1-percentage-point surprise
increase can be written as Ak φ for that particular variable.
The orthogonalization procedure suggested by Bernanke and Kuttner (2005) prohibits any con-
temporaneous reaction of the macroeconomic parameters derived from any economic announce-
ment, and in our model also, we did not consider this contemporaneous effect.
In our present VAR model, we employed BSE SENSEX (BSESSReturn) for return. Other predictive
variables are Real Interest rate (ReaIintRate) estimated as 91-day T-bill rate minus non-seasonally
adjusted CPI (In India, the CPI data series is non-seasonally adjusted and, therefore, we used it
directly without any adjustment), Relative Bill rate (RltvbRate) estimated as 91-day T-bill rate
minus 12 months lagged moving average, the change in the nominal interest rate measured by
change in the T-bill rate (ChngeTBrate), Dividend–Price ratio (BSEsDvdPrRatio), and Spread between
10 years bond and 91-day T-bill rate (SprdLT_ST). The Macroeconomic Surprise Vector comprises
six exogenous surprise variables and is used in the model. Those variables are Surprise in Monetary
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policy (SMpolicy), Surprise in GDP (SGDP), Surprise in WPI (SWPI), Surprise in CPI (SCPI), Surprise in
IIP (SIIP), and Surprise in CAD (SCAD).
The periodic time series data are necessary for VAR; hence, all variables along with the surprises
are employed considering their monthly measures. In case multiple monthly policy data are avail-
able for any particular macroeconomic parameter, the value of the corresponding surprise in
a month is calculated by taking average of the event-based daily data. This approach is generally
applicable only for monetary policy surprise, as, during the post-financial crises in 2008, there are
several occasions of unscheduled monetary policy announcements. In case there is no such policy
announcement in a particular month, the value of the surprise for that specific month is set to zero.
All data series were available from 1 April 2004 to 31 July 2016, except the data for dividend–
price ratio, which is available from September 2005. Since the dividend–price ratio is critical for the
Structural VAR model, we developed the model based on data from October 2005 to July 2016.
Taking into consideration all these criteria, we had 130 data points.
We constructed both the first-order and second-order unrestrictive VAR model. The lag length 1
gives minimum Schwarz Criteria (SC) value, whereas the lag length 2 generates minimum Akaike
Information Criteria (AIC). The SC criterion is supposed to be superior to the AIC for the large
sample size; hence, we applied the VAR model with one lag length. By restricting the lag length to
maximum one, the over-parametrization problem is not envisaged in the unrestrictive VAR model.
The impulse responses of stock return for 1 (one)-percentage-point change in six macroeconomic
surprises are calculated over a 10-month period from this VAR(1) model, and the increase in the
k-month response to a 1-percentage-point surprise increase is calculated as Ak φ. With this model, the
impulse response of BSE Sensex return associated with 1-percentage-point change in the six macro-
economic surprises over a 10-month horizon is shown in Figure 7. In general, the impact of the stock
returns originating due to different surprises is small and diminutive over the period. The magnitude of
the effects ranges between 2.6% (monetary policy surprise) and 0.03% (CPI surprise). The monetary
policy surprise results in the initial decline of the stock returns, followed by recovery in subsequent
months. This finding is consistent with the general expectation of negative co-relation. The GDP
surprise also leads to an initial decline, but the magnitude of decline is much less. The WPI surprise
results in the initial increase of the stock returns, which subsequently decrease. The CPI surprise results
in a considerable decline of the stock returns. The IIP surprise leads to negative stock returns, whereas
the CAD surprise leads to positive stock return. We saw an exactly similar pattern with NIFTY 50 data,
which is also representative of large-sized firms (Figure 8). All these behaviors of stock returns against
various macroeconomic surprises are institutively obvious, except initial positive reaction against WPI
and CAD surprises. One possible reason could be the markets’ perceptions immediately after surprise.
The market probably reacts positively after surprise because of the perceived increased profitability on
account of price and export competitiveness, but gradually that positive sentiment dies down as other
macroeconomic parameters, particularly CPI, starts showing adverse reactions.
While comparing the results on impulse response with that of the event study, all the signs are
the same, excluding the WPI surprise. However, along with the monetary policy surprise, it is
observed that the GDP, WPI, CAD, IIP, and CPI shocks show a significant impact. According to the
dynamics and magnitude, the monetary policy, GDP, WPI, CAD, and IIP surprises majorly influence
the stock returns, and the influence of CPI surprise is relatively less. This pattern is also found to be
consistent with the event study.
In the event study, we observed the industry effect on monetary policy surprise and found that
some capital-intensive sector or sectors affected by economic cycle are more sensitive to shock
than the recession-proof sectors, and the findings are consistent with that of Ehrmann and
Fratzscher (2004). Though in the event study, we did not observe the differential effect of other
macroeconomic surprises on the representative industrial indices; however, in VAR, we observed
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Figure 7. Impulse response of Impulse response : 1- percentage- Impulse response : 1- percentage-point

BSE Sensex to monetary policy point change in Monetary Polcy change in GDP Suprise on BSE Sensex
and macroeconomic surprises Suprise on BSE Sensex 0.05
with lag length 1.
0.5
% change -BSE Sensex

0

0 0 1 2 3 4 5 6 7 8 9 10
-0.5 0 1 2 3 4 5 6 7 8 9 10 -0.05
-1 -0.1
-1.5
-0.15
-2
-0.2
-2.5
-3 -0.25
Months Months
Impulse response : 1- percentage- Impulse response : 1- percentage-point

point change in WPI Suprise on BSE change in CPI Suprise on BSE Sensex
Sensex 0.005

0.06 0
0.05 -0.005 0 1 2 3 4 5 6 7 8 9 10
0.04 -0.01
0.03 -0.015
0.02 -0.02
0.01 -0.025
0 -0.03
-0.01 0 1 2 3 4 5 6 7 8 9 10 -0.035
Months Months

point change in IIP Suprise on BSE change in CAD Suprise on BSE Sensex
Sensex
0.25
0.01
0.2
0
0 1 2 3 4 5 6 7 8 9 10 0.15
-0.01
0.1
-0.02
-0.03 0.05
-0.04 0
0 1 2 3 4 5 6 7 8 9 10
-0.05 -0.05
Months Months
the differential effect. Though the impact originating from the initial surprise is small and diminu-
tive over the period, the recovery period varies with the industry category. In VAR analysis, we
expected a differential outcome of cyclical sector and recession-proof sector and thus selected the
BSE Metal as the representative of cyclical sector and BSE Healthcare as the representative of
recession-proof sector. The impulse-response functions of BSE Metal and BSE Healthcare are
plotted in Figures 9 and 10, respectively. According to our expectation, the initial reaction of BSE
Metal is higher than BSE Healthcare in all six surprises parameters, and each response is very
different from the BSE Sensex. We further tested the industry response with other industry-specific
indices. In the BSE BankEx (Banking Index), we expected that the stock reaction will be more in
monetary policy, GDP surprises, and CAD surprise because of their direct implication on banking
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Figure 8. Impulse response of Impulse response : 1- percentage-

Impulse response : 1- percentage-point
NIFTY 50 to monetary policy point change in GDP Suprise on
change in Monetary Polcy Suprise on
and macroeconomic surprises NIFTY 50
NIFTY 50
with lag length 1.
0.5 0.05
0 0
% change -NIFTY 50
% change -NIFTY 50
-0.5 0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
-0.05
-1
-0.1
-1.5
-0.15
-2
-0.2
-2.5
-3 -0.25
-3.5 -0.3
-4 -0.35
Months Months
Impulse response : 1- percentage-point Impulse response : 1- percentage-

change in WPI Suprise on NIFTY 50 point change in CPI Suprise on
0.07 NIFTY 50
0.06 0.005
% change -NIFTY 50
% change -NIFTY 50
0.05 0
0.04 0 1 2 3 4 5 6 7 8 9 10
-0.005
0.03
-0.01
0.02
-0.015
0.01
0 -0.02
-0.01 0 1 2 3 4 5 6 7 8 9 10
-0.025
Months Months

change in IIP Suprise on NIFTY 50 point change in CAD Suprise on
0.01 NIFTY 50
0 0.2
% change -NIFTY 50
-0.01 0 1 2 3 4 5 6 7 8 9 10
% change -NIFTY 50
-0.02 0.15
-0.03
-0.04 0.1
-0.05
0.05
-0.06
-0.07 0
-0.08 0 1 2 3 4 5 6 7 8 9 10
-0.09 -0.05
Months Months
operation compared to WPI, CPI, and IIP surprises. We observed the impulse response of the VAR
model in line with our expectation (Figure 11). In the BSE IT Index (Figure 12), we observed very
short recovery time in all six surprises and relatively larger positive response on the CAD surprise.
The generic business model of Indian IT companies is greatly reliant on exports and offshore
clients, and therefore, the sector is expected to be less sensitive to domestic macroeconomic
surprises as seen in shorter recovery time.
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Figure 9. Impulse response of Impulse response : 1- percentage-point Impulse response : 1- percentage-

BSE Metal to monetary policy change in Monetary Polcy Suprise on point change in GDP Suprise on BSE
and macroeconomic surprises BSE Metal Metal
with lag length 1. 1 0.05
0
% change -BSE Metal

0
% change -BSE Metal

0 1 2 3 4 5 6 7 8 9 10 -0.05 0 1 2 3 4 5 6 7 8 9 10
-1
-0.1
-2 -0.15
-3 -0.2
-0.25
-4
-0.3
-5 -0.35
-6 -0.4
Months Months

Impulse response : 1- percentage-
change in WPI Suprise on BSE Metal
point change in CPI Suprise on BSE
0.18
Metal
0.16 0.01
% change -BSE Metal
0.14 0
% change -BSE Metal

0.12 -0.01 0 1 2 3 4 5 6 7 8 9 10
0.1
-0.02
0.08
-0.03
0.06
-0.04
0.04
0.02 -0.05
0 -0.06
-0.02 0 1 2 3 4 5 6 7 8 9 10 -0.07
Months Months

change in IIP Suprise on BSE Metal point change in CAD Suprise on BSE
0.02
Metal
0.5
0
% change -BSE Metal
% change -BSE Metal
0 1 2 3 4 5 6 7 8 9 10 0.4
-0.02
-0.04 0.3
-0.06 0.2
-0.08 0.1
-0.1 0
0 1 2 3 4 5 6 7 8 9 10
-0.12 -0.1
Months Months
In the event study, we also observed the size effect of monetary policy but did not observe the
differential effect of other macroeconomic surprises. In VAR analysis, we expected differential
dynamic response of large-sized, medium-sized, and small-sized firms, against both the monetary
policy and macroeconomic surprises. We selected BSE Sensex as the representative of large firms,
NIFTY 50 Midcap and NIFTY 100 Midcap as the representative of medium-sized firms, and NIFTY
100 Small Cap as the representative of small-sized firms. We found smaller firms are very sensitive
to monetary and macroeconomic surprises. The impulse responses on the macroeconomic sur-
prises and monetary policy surprises of small firms (Figure 13) are more than the medium-sized
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Figure 10. Impulse response of Impulse response : 1- percentage-point Impulse response : 1- percentage-point
BSE Health to monetary policy change in Monetary Polcy Suprise on change in GDP Suprise on BSE Health
and macroeconomic surprises BSE Health 0.002
with lag length 1. 0.5
0
0
% change -BSE Health

0 1 2 3 4 5 6 7 8 9 10

-0.5 0 1 2 3 4 5 6 7 8 9 10 -0.002
-1
-1.5 -0.004
-2
-0.006
-2.5
-3 -0.008
-3.5
-0.01
-4
-4.5 -0.012
Months Months
Impulse response : 1- percentage-point Impulse response : 1- percentage-point

change in WPI Suprise on BSE Health change in CPI Suprise on BSE Health
0.018 0.01
0.016

0
0.014
0 1 2 3 4 5 6 7 8 9 10
0.012 -0.01
0.01
-0.02
0.008
0.006 -0.03
0.004 -0.04
0.002
0 -0.05
-0.002 0 1 2 3 4 5 6 7 8 9 10 -0.06
Months Months

change in IIP Suprise on BSE Health change in CAD Suprise on BSE Health
0.0035 0.01
0.003 0
0.0025 -0.01 0 1 2 3 4 5 6 7 8 9 10
0.002 -0.02
0.0015 -0.03
0.001 -0.04
0.0005 -0.05
0 -0.06
0 1 2 3 4 5 6 7 8 9 10
-0.0005 -0.07
Months Months
firm (Figures 14 and 15). The response of large-sized firms is the least (Figure 7). However, since
the price to dividend ratio of NIFTY 100 Small Cap index is available from 17 November 2011, we
could perform the VAR analysis with relatively smaller data set. For size effect, the direction of VAR
analysis result is different from the result obtained in event analysis, but the VAR analysis result
confirms the findings of other sets of literature, Thorbecke (1997), Kiyotaki and Moore (1997),
Perez-Quiros and Timmermann (2000), etc., in which it has been shown that the response of stock
returns to monetary policy is larger for small firms. However, this confirmation is mostly because of
the type of firms representing different industries rather than the firm’s financial constraints as
theorized by those pieces of literature.
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BSE BankEx to monetary policy change in Monetary Polcy Suprise on change in GDP Suprise on BSE
and macroeconomic surprises
BSE BankEx BankEx
with lag length 1. 1 0.1
% change -BSE BankEx

0

0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
-1
-0.1
-2
-0.2
-3
-0.3
-4
-5 -0.4
-6 -0.5
Months Months

change in WPI Suprise on BSE BankEx change in CPI Suprise on BSE BankEx
0.0005 0.02

0
0
0 1 2 3 4 5 6 7 8 9 10
0 1 2 3 4 5 6 7 8 9 10 -0.02
-0.0005 -0.04
-0.001 -0.06
-0.08
-0.0015
-0.1
-0.002 -0.12
Months Months

BankEx
change in IIP Suprise on BSE BankEx change in CAD Suprise on BSE
0.02 BankEx
-BSE BankEx
0.01
0.020
0
0 1 2 3 4 5 6 7 8 9 10
-BSE BankEx
0 1 2 3 4 5 6 7 8 9 10 -0.020
-0.01
-0.02 -0.04 0 1 2 3 4 5 6 7 8 9 10
-0.02
% change
-0.03 -0.06
-0.04
-0.04 -0.08
% change
-0.06
-0.05 -0.1
-0.08 Months
-0.06
-0.07 -0.1
Months Months
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Figure 12. Impulse response of Impulse response : 1- percentage-point

BSE IT Index to monetary policy change in GDP Suprise on BSE IT Index
and macroeconomic surprises BSE IT Index 0.02
with lag length 1.
% change -BSE IT Index

1 0

0 -0.02 0 1 2 3 4 5 6 7 8 9 10
-1 0 1 2 3 4 5 6 7 8 9 10 -0.04
-2 -0.06
-3 -0.08
-4 -0.1
-5 -0.12
-6 -0.14
-7 -0.16
Months Months

change in WPI Suprise on BSE IT change in CPI Suprise on BSE IT Index
Index
0.05
0.014

0.012 0.04
0.01
0.03
0.008
0.006 0.02
0.004
0.01
0.002
0 0
-0.002 0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Months -0.01
Months

change in IIP Suprise on BSE IT change in CAD Suprise on BSE IT Index
Index 0.6
0.012
0.5
0.01
0.4
0.008
0.3
0.006
0.2
0.004
0.002
0.1
0 0
-0.002
0 1 2 3 4 5 6 7 8 9 10 -0.1 0 1 2 3 4 5 6 7 8 9 10
Months Months
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NIFTY 100 Small Caps to change in Monetary Polcy Suprise on change in GDP Suprise on NIFTY 100
monetary policy and macroe- NIFTY 100 Small Caps Small Caps
% change -NIFT 100 Small Caps

% change -NIFTY 100 Small Caps
conomic surprises with lag 1 0.02
length 1. 0.015
0
0 1 2 3 4 5 6 7 8 9 10 0.01
-1
0.005
-2 0
0 1 2 3 4 5 6 7 8 9 10
-0.005
-3
-0.01
-4
-0.015
-5 -0.02
Months Months

change in WPI Suprise on NIFTY 100 change in CPI Suprise on NIFTY 100

Small Caps Small Caps

0.05 0.14
0.04 0.12
0.1
0.03
0.08
0.02 0.06
0.04
0.01
0.02
0 0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
-0.01 -0.02
Months Months

change in IIP Suprise on NIFTY 100 change in CAD Suprise on NIFTY 100
Small Caps Small Caps

0.05 0.4
0 0.3
0 1 2 3 4 5 6 7 8 9 10
-0.05 0.2
-0.1 0.1
-0.15 0
0 1 2 3 4 5 6 7 8 9 10
-0.2 -0.1
Months Months
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Figure 14. Impulse response of Impulse response : 1- percentage- Impulse response : 1- percentage-point
NIFTY 50 MidCap to monetary point change in Monetary Polcy change in GDP Suprise on NIFTY 50
policy and macroeconomic sur- Suprise on NIFTY 50 MidCap MidCap
% change -NIFTY 50 MidCap

prises with lag length 1.

1 0.05
0 0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
-1
-0.05
-2
-0.1
-3
-0.15
-4
-5 -0.2
Months Months

point change in WPI Suprise on change in CPI Suprise on NIFTY 50
NIFTY 50 MidCap MidCap

0.008 0.025
0.006 0.02
0.015
0.004
0.01
0.002
0.005
0 0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
-0.002 -0.005
Months Months
Impulse response: 1- percentage- Impulse response : 1- percentage-point

point change in IIP Suprise on change in CAD Suprise on NIFTY 50
NIFTY 50 MidCap MidCap
0.01 0.25
0
-0.01 0 1 2 3 4 5 6 7 8 9 10 0.2
-0.02
0.15
-0.03
-0.04 0.1
-0.05
-0.06
0.05
-0.07 0
-0.08 0 1 2 3 4 5 6 7 8 9 10
-0.09 -0.05
Months Months
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Figure 15. Impulse response of Impulse response : 1- percentage-point

NIFTY 100 MidCap to monetary change in GDP Suprise on NIFTY 100
policy and macroeconomic sur- Midcap
NIFTY 100 Midcap
prises with lag length 1.
% change - NIFTY 100 Midcap

% change -NIFTY 100 Midcap
1 0.05
0
0 0 1 2 3 4 5 6 7 8 9 10
-0.05
0 1 2 3 4 5 6 7 8 9 10
-1 -0.1
-0.15
-2 -0.2
-0.25
-3
-0.3
-4 -0.35
-0.4
-5 -0.45
Months Months

change in WPI Suprise on NIFTY 100 change in CPI Suprise on NIFTY 100
Midcap Midcap

0.05 0.05
0.04 0.04
0.03 0.03
0.02 0.02
0.01 0.01
0 0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
-0.01 -0.01
Months Months

change in IIP Suprise on NIFTY 100 change in CAD Suprise on NIFTY 100
Midcap Midcap
0.01 0.3
0 0.25
0 1 2 3 4 5 6 7 8 9 10
-0.01
0.2
0.15
-0.02
0.1
-0.03
0.05
-0.04 0
0 1 2 3 4 5 6 7 8 9 10
-0.05 -0.05
Months Months
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6. Conclusion
The aim of this paper is to examine two issues—first is the sensitivity of simultaneous impact of
monetary and macroeconomic surprises in the Indian stock market, and second is the heterogeneity
of stock responses, characterized by industry type and firm size, to monetary policy and macroeco-
nomic surprises. Primarily, we conducted an event study that explores the instant effect of macro-
economic shocks on varied stock market indices. The result from the event study depicts that the
monetary policy surprise considerably affects the stock market than that of other macroeconomic
surprises. Theoretically, monetary policy surprises are negatively correlated to stock returns, and as
per our expectation, it is observed that the coefficients of monetary policy are negative for all indices,
and all the results are statistically significant as seen in our event study. We observed that the result is
consistent with the results estimated for the US stocks by Bernanke and Kuttner (2005), Rigobon and
Sack (2003), and Ehrmann and Fratzscher (2004). We further observed that the clear industry effect
with respect to monetary policy surprise, i.e., the response of stock against monetary policy, varies with
industries, which confirms the findings for the US stocks by Ehrmann and Fratzscher (2004) and
Bernanke and Kuttner (2005). We also observed the firm’s size effect against monetary policy surprise
upon measuring stock market response through the indices and found that the response of stock
market is maximum for large firms, which is followed by the medium-sized firm and the small firm. Our
finding is directionally different from the findings of other studies by Thorbecke (1997), Kiyotaki and
Moore (1997), and Perez-Quiros and Timmermann (2000). In those studies, it has been shown that the
response of stock returns to monetary policy is larger for small firms. However, the focus of those
studies is mainly on financial constraints, which becomes more relevant with the change in the credit
market conditions, and the changed scenario is expected to persist in the short and medium term.
Several studies have provided evidence about the lack of correlation between the firm size and the
financial constraints, for example, Carlino and DeFina (1998), Mojon et al. (2002), and Arnold and Vrugt
(2004). Moreover, upon using the different indices as the proxy for size, the industry effect might
dominate the size effect.
In the VAR analysis, we examined the dynamic impact of the macroeconomic surprises on
the stock market indices. Unlike the event study, which is only indicative of the fact that the
monetary policy is the only surprise variable that significantly affects stock returns, the VAR
analysis found the effect of the macroeconomic surprise variables on stock return, though the
other macroeconomic surprises are accountable for a small portion of the total variability of
the stock prices. The dynamic effect in the VAR analysis highlights that the impacts of surprise
variables are primarily at the shorter horizons, instantly after the shock. Consistent with the
result of the event study, the industry effect is also observed in VAR. The industry responses
to macroeconomic surprises are generally coherent with the industry characteristics. We
further observed the size effect in VAR analysis, as impulse responses of stock indices vary
with firm size—largest for small firms, lowest for large firms, and for medium firms the
responses are in-between. The direction of this size effect confirms the findings of
Thorbecke (1997), Kiyotaki and Moore (1997), and Perez-Quiros and Timmermann (2000).
Though both the event study and VAR analysis successfully conclude the heterogeneous
response of stock indices against monetary policy and macroeconomic surprises, whether
the response is dominated by industry effect or size effect depends on the composition of
firms in the indices.
While there are limited studies in this area even in the developed economy, none of the
studies have examined the simultaneous effect of both the monetary policy surprises and
the wide range of macroeconomic surprises in the Indian context. Through the implementa-
tion of the measures of monetary policy as well as other multiple macroeconomic surprises,
the paper separates the unanticipated elements of the monetary policy variable and other
macroeconomic indicators. The understanding of this stock market dynamics can help mar-
ket participants and policymakers to develop the right strategy to achieve their desired
objectives.
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In this study, we provided a few conjectures in relation to the interpreted results in the
Indian context. During the study period, the uncertainty present in the Indian macroeconomic
fundamentals was rather low because of the functioning of its well-regulated financial
system. In this relatively stable macroenvironment, the surprises occurred was low. Further,
the Indian stock market is well integrated with the active participation of FPIs and FIIs
investment, and many of the stock market reactions may not be governed by domestic
macroeconomic surprises, rather it depends on global developments. A firm-level analysis
that includes a wider class of firms representing different sizes, different industries, and
ownership can help to substantiate these interpretations. The exploration of stock market
reaction on macroeconomic and monetary policy surprises along with these linkages can be
considered for future research.
Funding Campbell, J. Y., & Ammer, J. (1993). What moves the

The authors received no direct funding for this research. stock and bond markets? A variance decomposition
for long-term asset returns. Journal of Finance, 48(1),
Author details 3–37. doi:10.1111/j.1540-6261.1993.tb04700.x
Santanu Pal1 Canova, F. (2005). The transmission of US shocks to Latin
E-mail: efpm03007@iiml.ac.in America. Journal of Applied Econometrics, 20(2),
Ajay K Garg2 229–251. doi:10.1002/(ISSN)1099-1255
E-mail: ajaygarg@iiml.ac.in Carlino, G., & DeFina, R. (1998). The differential regional
1
Fellow Researcher in Finance, Indian Institute of effects of monetary policy. Review of Economics and
Management Lucknow, Lucknow, India. Statistics, 80(4), 572–587. doi:10.1162/
2
Department of Finance and Accounting, Indian Institute 003465398557843
of Management Lucknow, Lucknow, India. Chen, N. F., Roll, R., & Ross, S. A. (1986). Economic forces
and the stock market. Journal of Business, 59(3),
Citation information 383–403. doi:10.1086/296344
Cite this article as: Macroeconomic surprises and stock Christiano, L. J., Eichenbaum, M., & Evans, C. (1996). The
market responses—A study on Indian stock market, effects of monetary policy shocks: Evidence from the
Santanu Pal & Ajay K Garg, Cogent Economics & Finance flow of funds. Review of Economics and Statistics, 78
(2019), 7: 1598248. (1), 16–34. doi:10.2307/2109845
Dedola, L., & Lippi, F. (2005). The monetary transmission
Notes mechanism: Evidence from the industries of five
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Macroeconomic surprises and stock market

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Keywords: macroeconomic surprise; monetary policy surprise; stock market response;

3. Methodology and data

Surprise ¼ Actual data Forecast data

Figure 1. GDP surprise. GDP Surprise

Actual Forecast Surprise

Figure 2. WPI surprise. WPI Surprise

Actual Forecast Surprise

Figure 3. CPI surprise. CPI Suprise

Figure 4. IIP surprise. IIP surprise

Actual Forecast Surprise

Figure 5. CAD surprise. CAD Surprise

Surprise (Bn USD)

Actual Forecast Surprise

Figure 6. Monetary policy Monetary policy surprise

91 days -Tbill rate Surprise

4. Event study and findings

it ¼ βst þ θxt þ γzt þ εt (1)

st ¼ αit þ φxt þ δzt þ ηt (2)

Stock return ¼ ln ðStþ1 Þ lnðSt Þ (3)

Stock return ¼ Constant þ β1 GDPsurprise þ β2 IIPsurprise þ β3 WPIsurprise þ β4 CPIsurprise

5. VAR analysis and findings

ytþ1 ¼ log ðExcess return of equityÞ

Equation (5) can be rewritten with simplified notation as

Δk1;t is the change in the nominal interest rate.

Therefore, the relative bill rate is defined as,

ztþ1 ¼ Azt þ wtþ1 (10)

where ztþ1 is np 1 matrix, A is the np np coefficient matrix, and w is a sequence of a serially

where sy and sr are appropriate 1 np selection matrix.

For Equation (15), the unexpected excess return can be rewritten as

ztþ1 ¼ Azt þ φxtþ1 þ w?

Figure 7. Impulse response of Impulse response : 1- percentage- Impulse response : 1- percentage-point

% change -BSE Sensex

% change -BSE Sensex

Impulse response : 1- percentage- Impulse response : 1- percentage-point

% change -BSE Sensex

Impulse response : 1- percentage- Impulse response : 1- percentage-point

Figure 8. Impulse response of Impulse response : 1- percentage-

Impulse response : 1- percentage-point Impulse response : 1- percentage-

Impulse response : 1- percentage-point Impulse response : 1- percentage-

Figure 9. Impulse response of Impulse response : 1- percentage-point Impulse response : 1- percentage-

% change -BSE Metal

% change -BSE Metal

Impulse response : 1- percentage-point